Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
Tapering is imminent and investors should now focus on the size of the withdrawal rather than its timing.
All eyes were on the August employment report released last Friday because of its implications for the start of Fed tapering. In particular, investors were fixated on the unemployment rate because the Fed had pegged its policy decisions to a decline in the number of people out of work. And while we did see an improvement in the jobless rate, it was driven by a negative trend—a lower labor-force participation rate, or fewer unemployed people actively looking for work. In fact, it marked the lowest labor-force participation rate in 35 years.
However, despite the report’s myriad flaws, we believe the Fed will most likely begin to taper quantitative easing at its September meeting. Here’s why:
The jobs report wasn’t awful enough.
At this point, only a huge negative surprise in non-farm payrolls
could have derailed the Fed’s plans to begin unwinding its bond-buying program.
Economic conditions are improving.
Other data we’ve seen this summer points toward a recovery. For example, last week the August ISM Manufacturing Index showed stronger-than-expected activity. Specifically, new orders were very strong, coming in above 60 for the first time in almost two-and-a-half years, which implies solid growth. In addition, the August ISM Non-Manufacturing Index came in at 58.6, a level not seen since the peak of the last recovery. The employment sub-index was a particular bright spot, rising 3.8 points for the month. It’s an important employment indicator because services make up more than two-thirds of the economy.
There’s a dearth of data in the short run.
There are no economic releases before the Sept. 17-18 FOMC meeting that have the potential to sway Fed officials not to taper. This week should be fairly slow.
Hold Close a Tiny Taper
To be sure, attention must now turn to what this taper will look like when it happens. Since the jobs report was so lackluster, it opens the door wide for a “tiny taper” of only a $5-billion to $10-billion reduction in QE. The Fed’s clearly concerned with maintaining stability in the capital markets so easing into tapering seems prudent, especially given other possible headwinds for the economy such as a budget showdown in Washington. With a hawk on the FOMC, Kansas City Fed President Esther George, advocating a $15 billion taper, there’s a very real possibility that central bankers will start with a slight retreat from QE.
In addition, there’s a chance that when tapering occurs, it will only include government bonds initially. That’s because we’re already seeing the negative impact that taper talk has had on the housing recovery. Housing is a critical component of the recovery because the wealth effect
is tied so closely to home prices. And we’ve seen evidence of a stalling housing rebound in the last few months.
But a look at current jumbo mortgage rates versus conventional mortgage rates reveals an interesting phenomenon. Expectations that the Fed will curtail its mortgage-backed securities purchases have driven up conventional mortgage rates—so high that they’re now slightly above jumbo mortgage rates. Indeed, jumbo mortgages, loans that exceed the limit for loans eligible for backing by Fannie Mae and Freddie Mac, on average, are charging 4.71% for a 30-year fixed-rate mortgage whereas a 30-year fixed-rate conforming mortgage was at 4.73% last week, according to the Mortgage Bankers Association. It’s a real anomaly that speaks to the serious implications of tapering MBS for housing. Cutting back on MBS purchases could drive mortgage rates significantly higher, something that the Fed is clearly concerned about.
Between now and the next Fed meeting, look for the market to continue to digest the jobs report and what it portends for monetary policy decisions. Further, there will be a lot of debate this week over what tapering may look like in terms of both quantity and quality.
Expect a lot of volatility over the next few months as the stock market transitions from being largely supported by monetary policy to one that’s fueled by fundamentals.
The Upshot is available as a subscription for financial professionals only. New issues will be delivered via email every Monday. Your email address must be in our records for your subscription to take effect.